Tuesday, March 25, 2008

Introducing… Fannie and Freddie: Fannie Mae and Freddie Mac are two government-sponsored enterprises (or GSEs) established by Congress to promote the laudable (and politically popular) objective of home ownership.

How do they do that? They go out and buy large quantities of so-called “conforming loans” from conventional mortgage lenders (e.g. your local bank). They then pool them together and repackage them into “mortgage-backed securities” (MBS), which they sell on to private investors. We’ll call that securitization. This allows your local bank to offload the burden of these loans from its balance sheet and extend new mortgages, so that your neighbor, too, can join the homeowners’ club.

On top of securitizing mortgages, Fannie and Freddie also invest in MBS issued by themselves and by other issuers. They have thus helped create a vast and liquid market for MBS, which has allowed investors like you and me invest in mortgages as a (higher-yielding) alternative to, say, government bonds. In turn, this means that potential losses from mortgage defaults are no longer borne by just a few banks, but by a much wider pool of investors. Ergo a more stable financial system and lower interest rates for borrowers.

Now, given that “home ownership” is synonymous with “political points” on both sides of the aisle, Fannie and Freddie enjoy a number of special benefits under federal law. Among them are income tax exemptions, large savings from not having to register their securities with the Securities and Exchange Commission and, importantly, eligibility of their securities for use by the Fed in its conduct of monetary policy.

Many have interpreted the latter as implying a hidden government guarantee on the securities issued by the GSEs. And even though the government has gone at lengths to deny it, you can’t blame investors for believing that Fannie and Freddie are simply “too big to fail”: Their mortgage portfolios are gigantic and Congressional support for their social role strong enough to ensure that, if stuff hit the fan, the government would bail them out. In all, this has meant lower borrowing costs for both GSEs as well as very low capital requirements to support their investment activities.

Dangerous? Perhaps. But few are those complaining, as Fannie and Freddie are ultimately passing on their lower funding costs to mortgage borrowers: You, that is, unless you are one of these “non-conforming” types (meaning “filthy rich” or “jobless and hopeless”). If so, you could try your luck with more expensive alternatives, such as the “jumbos” (loans above $417,000) or the now-famous “NINJA” mortgages, so coined for their ridiculously lax lending standards (No Income No Job No Assets).

Those economists! As I said, some have been complaining calling, inter allia, for caps in the GSEs’ portfolios and higher capital requirements. Unsurprisingly, many are economists, and not because they’re filthy rich non-conformists. The argument goes that the enormous expansion of the GSEs' investment portfolios is potentially very risky for the mortgage market and (yes!) the American taxpayer. And why is that?

Too extended for their capital: Since Fannie and Freddie can get away with very little capital, they have been financing their acquisitions of MBS with (vast amounts of) debt, which is now held by a very wide base of investors, from commercial banks, to your mutual funds to the Chinese Central Bank. So these guys would suffer heavy losses if the GSEs got into trouble. And while you might care little about the Chinese, losses by domestic banks could have serious implications for the functioning of the financial system. Unless the government stepped in of course..

Too big for the markets: Fannie and Freddie are big players in the markets for derivatives such as options or interest rate swaps. These are instruments that help the GSEs match the (less predictable) profile of their income from mortgages (i.e. interest and principal payments) with the (more predictable) profile of their own debt payments. Now, because of their size and the nature of their investment needs, the GSEs can exacerbate price movements in derivatives markets. And that’s not that desirable, particularly at a time when bond prices are already on a downward spiral. Participants in those markets are thus exposed to the vagaries of Fannie and Freddie’s “mood,” and not just them; holders of traditional bonds are also exposed, due to “feedback” effects from the derivatives “universe.”

Add to this a couple of multi-billion-dollar accounting scandals by both GSEs (designed to keep Wall Street happy and inflate the bonuses of top Fannie and Freddie executives) and calls for greater regulation were finally answered.

Plus ça change… But times have changed, again! With the Fed and the Treasury desperate to stop the downward spiral in MBS prices, Fannie and Freddie have been summoned into action. Caps on their investment portfolios lifted, requirement on the surplus capital they need to hold reduced, and the definition of “conforming” expanded to include some jumbos. Thus armed, the GSEs have been given instructions to provide a couple of hundred billion dollars of badly-needed liquidity and help resuscitate the mortgage market.

But what’s wrong with a little regulatory transgression? Well, nothing, really, other than the fact that there seemed to be a pretty good reason for having introduced the (now-lifted) regulations in the first place. Oh yes, and the fact that the transgression may end up being longer than “temporary”, at the cost of fresh build-ups in the concentration of risk in the MBS markets. Not to mention the tremendous linguistic appeal in calling a spade a spade (or a bailout a bailout): I mean, since the ultimate bearer of risk is the government, would it not be more “clean-cut” if the government were to buy the MBS itself, instead of creating potential time-bombs for the taxpayer?

In the end, officials are making a brave bet: That the crisis is at heart one of liquidity rather than solvency, that current prices don’t make sense, and that (hence) the downside risks to the Fed or the Fannies of this world are limited. So let’s see. Markets seem indeed a touch happier these days, though I’d dare observe they looked particularly happy on Monday, on rumors that the Fed was considering purchases of MBS to support prices… that’s right, the B(ailout)-word!